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CHAPTER 7: The CPI and the Cost of Living

CHAPTER 7: The CPI and the Cost of Living. CHAPTER CHECKLIST. Explain what the Consumer Price Index (CPI) is and how it is calculated. Explain the limitations of the CPI as a measure of the cost of living.

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CHAPTER 7: The CPI and the Cost of Living

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  1. CHAPTER 7:The CPI and the Cost of Living

  2. CHAPTER CHECKLIST • Explain what the Consumer Price Index (CPI) is and how it is calculated. • Explain the limitations of the CPI as a measure of the cost of living. • Adjust money values for inflation and calculate real wage rates and real interest rates.

  3. LECTURE TOPICS • The Consumer Price Index • The CPI and the Cost of Living • Nominal and Real Values

  4. 7.1 THE CONSUMER PRICE INDEX • Consumer Price Index (CPI) • A measure of the average prices paid by urban consumers for a fixed market basket of consumer goods and services. • The ‘market basket’ is based on average purchases in a base period, derived from an expenditure survey of the relevant households. • No household necessarily actually buys the basket; because it is an average, it includes both apartment rent and cost of owning a house; and both costs of owning a car and cost of bus fares, etc.

  5. 7.1 THE CONSUMER PRICE INDEX • Reading the CPI Numbers • The CPI is defined to equal 100 for a period called the reference base period. • Reference base period • A period for which the CPI is defined to equal 100. Currently, the reference base period is 1982-1984, although the BLS [Bureau of Labor Statistics, which collects the data and calculates the CPI] intends to start revising the reference base period market basket every two years.

  6. 7.1 THE CONSUMER PRICE INDEX • In November 2001, the CPI-U was 177.4. • The average of the prices paid by urban consumers for a fixed market basket of consumer goods and services was 77.4 percent higher in November 2001 than it was on average during 1982-1984. What this means is that the basket of goods and services that cost $100 on average during 1982-84, in November 2001 cost $177.40 [on average over the whole country; there are regional differences, the New York City CPI is higher than the Atlanta one].

  7. 7.1 THE CONSUMER PRICE INDEX • Constructing the CPI • Three stages: • Selecting the CPI basket • Conducting the monthly price survey • Calculating the CPI

  8. 7.1 THE CONSUMER PRICE INDEX • The CPI Basket • Make the relative importance of the items in the CPI basket the same as in the budget of an average urban household. Based on expenditure surveys. • CPI-U • Measures the cost of the average basket bought by all urban households. • CPI-W • Measures the cost of the average basket bought by urban wage earners and clerical workers.

  9. 7.1 THE CONSUMER PRICE INDEX This shopping cart is filled with the items that an average household buys. Figure 7.1 shows the CPI basket.

  10. 7.1 THE CONSUMER PRICE INDEX • The Monthly Price Survey • Each month, BLS employees check the prices of the 80,000 goods and services in the CPI basket in 30 metropolitan areas. BLS publishes estimates of CPI-U and CPI-W for the whole country, and for each of those 30 metropolitan areas and for regions of the country, on its website. • http://www.bls.gov/cpi/

  11. 7.1 THE CONSUMER PRICE INDEX • Calculating the CPI • The CPI calculation has three steps: • Find the cost of the CPI basket at base period prices. • Find the cost of the CPI basket at current period prices. • Calculate the CPI for the base period and the current period.

  12. 7.1 THE CONSUMER PRICE INDEX Table 7.1 shows the consumer price index: a simplified CPI calculation.

  13. Cost of CPI basket at current period prices x 100 Cost of CPI basket at base period prices $50 $70 x 100 x 100 = 100 = 140 For 2000, the CPI is: $50 $50 For 2001, the CPI is: 7.1 THE CONSUMER PRICE INDEX CPI =

  14. CPI in current year - CPI in previous year x 100 Inflation rate = CPI in previous year 140 - 100 x 100 = 40 percent Inflation rate = 100 7.1 THE CONSUMER PRICE INDEX • Measuring Inflation • Inflation rate • The percentage change in the price level from one year to the next.

  15. 7.1 THE CONSUMER PRICE INDEX Figure 7.2 shows the CPI in part (a) and the inflation rate in part (b).

  16. 7.1 THE CONSUMER PRICE INDEX In part (a), the price level has increased every year. The rate of increase was rapid during the early 1980s and slower during the 1990s.

  17. 7.1 THE CONSUMER PRICE INDEX In part (b), the inflation rate was high during the early 1980s, but low during the 1990s.

  18. 7.2 THE CPI AND THE COST OF LIVING • Cost of living index • A measure of changes in the amount of money that people would need to spend to achieve a given standard of living. • Because the CPI is based on the cost of a fixed basket of goods and services, it is often used as a measure of the cost of living. BUT, the basket is an average and fixed; real people buy different baskets of goods and services, and will change what they buy if relative prices differ. There can be no ‘true’ cost of living index – so-called ‘index number problem,’ if both quantities and prices change, there is no ‘perfect’ index number.

  19. 7.2 THE CPI AND THE COST OF LIVING • The Biased CPI • The main sources of bias in the CPI are: • New goods bias • Quality change bias • Commodity substitution bias • Outlet substitution bias

  20. 7.2 THE CPI AND THE COST OF LIVING • New Goods Bias • New goods often do a better job than the old goods that they replace, but cost more. • The arrival of new goods puts an upward bias into the CPI and its measure of the inflation rate. • Quality Change Bias • Better cars or DVD players may cost more than the older versions they replace. • A price rise that is a payment for improved quality is not inflation but might get measured as inflation.

  21. 7.2 THE CPI AND THE COST OF LIVING • Commodity Substitution Bias • If the price of beef rises faster than the price of chicken, people buy more chicken and less beef. • The CPI basket doesn’t change to allow for the effects of substitution between goods. • Outlet Substitution Bias • If prices become perceived as higher in some kinds of store than others [e.g. discount chain versus traditional department stores], more purchases will be made in the cheaper outlet. • The CPI basket doesn’t change to allow for the effects of outlet substitution.

  22. 7.2 THE CPI AND THE COST OF LIVING • The Magnitude of the Bias • The Boskin Commission estimated the bias to be 1.1 percentage points per year. • If the inflation rate reported is 3.1 percent, Boskin and colleagues estimated the true inflation rate is probably 2.0 percent. [Others dispute the size of this estimate] • To reduce the bias, the BLS has decided to increase the frequency of its Consumer Expenditure Survey and to revise the CPI basket every two years.

  23. 7.2 THE CPI AND THE COST OF LIVING • Two Consequences of the CPI Bias • Two main consequences of the bias in the CPI are: • Distortion of private agreements • Increases in government outlays • Distortion of private agreements • Many private agreements, such as wage contracts, are linked to the CPI. • If the CPI is biased, these agreements might deliver an outcome different from that intended by the parties.

  24. 7.2 THE CPI AND THE COST OF LIVING Table 7.2 shows a three-year wage deal. In this example, the wage rate rises by $1.01 more after three years than the agreement intended because of CPI bias.

  25. 7.2 THE CPI AND THE COST OF LIVING • Increases in Government Outlays • Close to a third of federal government spending is linked directly to the CPI. • The CPI is used to adjust: • 48 million Social Security benefit payments • 22 million food stamp payments • 4 million pensions for retired military personnel, federal civil servants, and their surviving spouses • the budget for 27 million school lunches

  26. 7.2 THE CPI AND THE COST OF LIVING • The GDP Deflator: A Better Measure? • In principle, the GDP deflator is not subject to the biases of the CPI because it is a chain index that uses the basket of goods and services produced in the current year and the preceding year [it does have some other problems]. • In practice, the GDP deflator suffers from some of the CPI’s problems because the Commerce Department does not measure the physical quantities of all the goods and services that are produced directly – because it is not really feasible to do so.

  27. 7.2 THE CPI AND THE COST OF LIVING • Instead, to estimate quantities, the Commerce Department divides expenditures by price indices. • And one of these price indices is the CPI. • So the biased CPI injects some bias into the GDP deflator.

  28. 7.2 THE CPI AND THE COST OF LIVING Figure 7.3 shows the two measures of inflation in part (a) and the corresponding two measures of the price level in part (b).

  29. 7.2 THE CPI AND THE COST OF LIVING The two measures of the inflation rate in part (a) fluctuate together, but the CPI measure rises more rapidly than the GDP deflator measure.

  30. 7.2 THE CPI AND THE COST OF LIVING In part (b), and the price levels get farther apart. Both measures probably overstate the inflation rate.

  31. CPI in 2000 Price of stamp in 1900 dollars x CPI in 1900 171.3 = 42.8 cents = 2 cents x 8 7.3 NOMINAL AND REAL VALUES • Dollars and Cents at Different Dates • To compare dollar amounts at different dates, one approach is to use the CPI at those dates. • Convert the price of a 2-cent stamp in 1900 into its 2000 equivalent: Price of stamp in 2000 dollars =

  32. 7.3 NOMINAL AND REAL VALUES • Nominal and Real Values in Macroeconomics • Macroeconomics makes a big issue of the distinction between nominal values and real values: • Nominal GDP and real GDP • Nominal wage rate and real wage rate • Nominal interest rate and real interest rate • We studied the distinction between and calculation of nominal and real GDP in Chapter 5. Here, we’ll look at the other two.

  33. Real and money variables • “Real” is “unreal” -- something you cannot measure directly [jargon] • In general, ‘money’ equals ‘real’ times ‘price index’ [divided by 100 if index has 100 as base]

  34. 7.3 NOMINAL AND REAL VALUES • Nominal and Real Wage Rates • Nominal wage rate • The average hourly wage rate measured in current dollars. • Real wage rate • The average hourly wage rate measured in the dollars of a given reference base year.

  35. Nominal wage rate in 1999 x 100 Real wage rate in 1999 = CPI in 1999 $23.02 x 100 = $13.82 Real wage rate in 1999 = 166.6 7.3 NOMINAL AND REAL VALUES To calculate the real wage rate, we divide the nominal wage rate by the CPI and multiply by 100. That is: The $13.82 amount is in 1982-1984 dollars – the CPI base period.

  36. 7.3 NOMINAL AND REAL VALUES Figure 7.4 shows nominal and real wage rates: 1970–2000. The nominal wage rate has increased every year since 1970. The real wage rate decreased during the late 1970s and increased most rapidly during the late 1990s.

  37. 7.3 NOMINAL AND REAL VALUES • Nominal and Real Interest Rates • Nominal interest rate • The percentage return on a loan expressed in current dollars. • Real interest rate • The percentage return on a loan expressed in constant purchasing power—the nominal interest rate adjusted for the effects of inflation. • Real interest rate = Nominal interest rate – Inflation rate • [Approximation good for ‘normal’ levels]

  38. 7.3 NOMINAL AND REAL VALUES Figure 7.5 shows nominal and real interest rates: 1970–2000. The nominal interest rate increased during the high-inflation 1980s. During the 1970s, the real interest rate was negative for a while.

  39. Example:Importance of comparing variables in real terms over time. Brazil:(cruzeiros)

  40. GDP1992 - GDP1991 X 100 = GDP1991 Growth Rate Growth Rate = % GDP

  41. Example: Growth Rateof Brazilian money GDP 618,600 - 57,100 = X 100 983.36% 57,100

  42. Growth of Real GDP in Brazil • Growth rate is [10,930 - 11,029]/(11,029) times 100 %, i.e. - 0.9% • Minus 0.9% -- real GDP fell • The difference was inflation -- the price level went up faster than money GDP increased

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